Jim Chanos: The Psychology Of Short SellingVW Staff
An interview with famed short seller and founder of Kynikos Associates, Jim Chanos. In this interview, Jim discusses the psychology needed to be a short seller and traits of a successful short seller. Jim also talks about China and his prediction it is heading for a crash.
0:18 Your background?
1:47 Psychology and skill sets of short selling?
6:16 China is heading for a crash?
10:53 Risk in short selling?
13:05 What do institutional investors look for?
Welcome to West TV. Today we have Jim Chanos founder of Kynikos Associates and legendary short seller. Jim thanks for joining us today. My pleasure. Thanks for having me. Can you give us an introduction to your background and to your firm. I got onto Wall Street in 1980 to graduating from college. I first joined the investment bank that no longer exists in Chicago blithesome spent a little over a year doing investment banking deals and being the junior analyst on the team. In 1982 I left to join a small retail brokerage firm which had been founded by Blasius been partners called Gilford Securities and it was there that I sort of stumbled on my first short idea which was Baldwin United and Valde united. Shortly after we got involved filed for bankruptcy and was the largest financial bankruptcy in the US. Up until that time and that got me thinking about the whole idea of whether or not there was a business to be made in fundamentally analyzing short ideas. I formed Kinko’s associates in 1985 as a hedge fund management company to manage short only partnership. It subsequently has diversified a bit and grown quite a bit since then but we run about 6 billion dollars. Five and a half billion of that short only both global and U.S. and about half a billion in long short fund called the Opportunity Fund which we’ve been running for nine years. Jim are there different psychological profiles and possibly different skill sets behind typical long only investors and successful short sellers. When we talk about the skill set and the psychological profile of short selling.
I used to think they were the same when I first started. And I no longer think that what I’ve said about this is that while the actual skill set for looking at companies should be exactly the same whether you had something you know long or short you should be analyzing the same type of ratios making the same kinds of phone calls. I think the psychological behavioral part of the equation is completely different. We like to point out is that almost everybody that will view this video for example is the beneficiary of a positive reinforcement cycle in their life that is they were told to study hard by their parents go to good schools get good grades go to better schools get a good job work hard you know get promoted be paid well sold and so forth. The so-called virtuous cycle but studies have also shown that most rational people including people who fit that profile their decision making breaks down in an environment of negative reinforcement. The ultimate example of which would be an interrogation where your ability to withhold information rationally is broken down by by physically or mentally by by very different techniques. If you think of Wall Street it’s a giant positive reinforcement machine. Basically I mean every morning on my Blackberry or check Bloomberg at 5:00 in the morning and of the hundred short ideas that we have in our Global Fund I can pretty much confidently predict that there’s going to be about 20 to 25 percent. Every day was going to be some sort of commentary Research Report analyst by recommendation reaffirmed estimates raised CEO is on Bloomberg or CNBC.
And generally its noise generally there’s not much informational content in that but it’s positive noise. It’s why you should be investing in Company ABC or why it’s a takeover target or why they have new products. And most people don’t even sort of notice that because they’re in the business of going long securities. And I like to say it’s the music that plays in the background of the investment world. But if you’re short seller that’s negative reinforcement you’re being told one quarter of your portfolio every morning that you’re wrong stocks can go up a lot for these reasons and for those reasons. And for this rumor and for most people that becomes a difficult environment in which continue to think clearly about their investments because there’s a constant drumbeat of just negative reinforcement that you’re in correct or incorrect and an awful lot of people are in this sort of life’s too short camp. I just don’t need this. And it’s why an awful lot of very good investors by the way are not really good short sellers. We point this out to a lot of hedge fund investors that in fact you know people who do the long shot long sight and short sighted equally well are very very rare. So it’s one of the reasons I think what we have. Business number one but number two I think it’s an interesting insight into some of the asymmetries of the long side and the short side. And there’s an awful lot of them on the short side that don’t exist in regular investing a lot of people don’t think through. This is clearly one of them.
One of the biggest ones I think it really is rooted in the whole idea of behavioral finance and how people think of the shorts I differently and the risks differently than they do. Longside one of the things I hear often from people is well you know I don’t like to shut short stocks because they can go up to and you know infinitely but they can only go to zero. And I of course always point out that I’ve seen many more stocks go to zero to go to infinity. So to alleviate that like any other investor would through portfolio structure and risk parameters which become paramount on the short side. But again it’s part of that behavioral thinking where they look at short positions often discretely as individual ideas but yet most people will look at the portfolio as a portfolio and they think differently when it comes to the short side and alongside. And we try to take advantage of that. You’ve been outspoken about the fact that China is headed for a crash in your opinion. Do you still feel that way or do you think China can engineer any kind of soft landing. We came to China a lot of people get the run. We are not macro people ever and I’ve stressed that we are smart people but we came at China for exactly that reason. In the summer of 2009 we were look at the mining stocks and we were trying to figure out why it was in the teeth of a global recession. We don’t know when the mining companies were basically reporting pretty close to record profits.
And I think the partners I knew intuitively was because of Chinese demand but we really wanted to get underneath that and see what was it about Chinese demand that was soaking up 80 percent of iron ore and 60 percent of cement and so much of the industrial commodity demand and went out we put our research team to work on it. By late summer early fall it was very apparent to us that it was due to this massive property and infrastructure buildup. And I remember sitting in a conference room like this one downstairs and my real estate guy analyst was putting some numbers up on the white board. And he pointed out that as of that moment fall of 0 9 there was 5.5 billion square meters of high rise construction going on in China half residential half commercial. And so I thought for a second realizing that was 60 billion square feet the way you had U.S. investor thinks. And I said Well Alex clearly that can’t be right. You must have missed a decimal point. Probably 6 billion square feet. He sort of looked at me with this worried look as I said no. He said I thought the same thing I triple check the numbers. It’s 60 billion square feet. Well half of that was being classified as office mix use. So I thought for a second I will cheat. That’s 30 billion loan for office and mixed use. And 30 billion square feet is a five foot by five foot office cubicle for every man woman and child in China. And that’s when it kind of hit me that the enormity of what was happening in China in terms of just simply high rise construction forgetting high speed rail and ports and airports. This was someplace simply staggering.
And all of that by the way has been completed since that that discussion in 0 9 and we’re on to building more so China to US started in an examination of the global iron ore companies and really has now morphed into a reasonably diverse portfolio of property companies developers construction companies cement companies steel companies as well as the original Iron ore miners in Australia and Brazil and now the Chinese banks because as we did more and more work it became very apparent to us that the Chinese banks are the nexus through which all this is credit driven investment is flowing. It’s an amazing story. I have no doubt that if the Chinese government says that they’re forecasting 7 1/2 percent growth this year and what is happening with the real economy they will print 7 1/2 percent or better but I don’t believe that that reflects reality. But the interesting thing about the China story getting back to the macro versus micro is as dire as I think the macro story is due to bad credit and credit extension that makes Greece and Spain and the U.S. look like child’s play is that when you get to the micro of the individual companies they look even worse and the accounting is horrible. They all seem to have negative cash flow. They all seem to have uncollectable receivables. They all seem to not earn their cost of capital. So as you dive deeper and deeper into the actual ideas they appear to be better and better.
Finally it appears as if the share market itself in Hong Kong is almost been designed for short selling in that even if you invest in the shares alongside the shares you don’t necessarily own the productive assets of the enterprise you might own shares in a parent company or a British Virgin Islands company or something else that has a profit participation arrangement with an operating company and they don’t even have financial statements. I mean every company is different of course but I would urge investors who are investing in China to really take a close look as to what they actually own. They might be surprised as far as global political macro risk what part does that play in your investing in your short selling. What are the new risks and short selling always has lots of risks that the long said isn’t one of the new risks we’ve had to contend with of course starting in await was the short selling bans which occurred first in the west and then have come back in 2011 in Europe and policymakers of course are always fighting the last war and you know these policies are always fraught with you know the laws of unintended consequences but in this case it was particularly bad because in the 0 8 instance where the authorities in Europe and the U.S. and UK were were banning short selling of financial shares what they didn’t realize was that almost all of the short selling and purchases of CBS contracts was not from people like me. In fact we were covering our shorts in the summer of 0 8 and fall boy short of a couple of years earlier. It was other financial institutions hedging off the counterparty risk. And that’s when death froze when the inability to do that froze up.
That’s when the funding crisis hit because suddenly if I had exposure to AIG when I had exposure to Lehman Brothers or whatever and I couldn’t hedge that properly I pulled my lines. And we pointed this out to the European regulators in the summer of last year when they were getting ready to. There were rumored to be short beds and we said you are going to make financing markets more difficult. The minute you put the ban out and sure enough that’s exactly what happened. So the largest largest institutions that short the shares of banks and financial companies and purchased CDs or other banks and financial companies because of the interrelated nature of their credit risks. And when you go into that market and try to say well we’re going to stop the short selling because we think it’s going to help pricing. The opposite happens. And that’s exactly what happened in Europe and they didn’t learn the lesson. The regulators in the U.K. and the U.S. did regarding institutional allocations. What is an institution looking for a way to invest with us when institutional investors come at us they come at us with some preconceived notions. And you know that well first of all you should be in our alternative investment bucket. But one of the things we point out to them is that we add value to other ways. Number Number one we really should be an offset to their core equity loan portfolio not their alternatives because we are it’s because of our peer mandate to be net short. We are at equal offset almost dollar for dollar to their long portfolio. So actually they should be looking at us in a much larger scope as opposed to being maybe 5 percent of their alternative bucket.
We should be five to 10 percent of their equity long bucket. That’s number one. Number two because of the nature of what we do. What we’re finding also is that more and more institutional clients are hiring us to run you know some substantial part of their portfolio on the short side but are also using us as an adviser generally meaning that they may have China exposure for example. So they’ll I’ll fly out to wherever they are and give them a talk about what we’re seeing going on in the Chinese financial markets and property markets. And that’s real value added beyond just the money they have with us. Because again in portfolio management sometimes the best way to outperform is to avoid the disasters and we’re in a disaster prediction business. So I’d like to say insurance company that pays dividends. It’s another way to look at it and I think that it makes a short only manager a little bit of a unique animal in this world.